A framework for action in fixed income

The aftermath of the global credit crisis left interest rates and bond yields close to the lowest levels in recorded history in many countries across the developed world (Figure 1). Indeed, the yield on cash and government bonds in some markets even
dipped below the rate of inflation.

23 June 2014

The aftermath of the global credit crisis left interest rates and bond yields close to the lowest levels in recorded history in many countries across the developed world (Figure 1). Indeed, the yield on cash and government bonds in some markets even dipped below the rate of inflation. Traditionally ‘riskier’ corporate bond yields have also fallen considerably, having been dragged down by government bond yields, while spreads have been compressed further in investors’ scramble for yield.

This environment presents investors with serious problems. Bonds have provided income, capital preservation, absolute returns, diversification, liability matching, liquidity and even inflation hedging in varying proportions and at varying times for decades. During that time, they have been a great buy-and-hold investment. But with yields at current levels, none of those things can be taken for granted any longer.

Unfortunately, there does not appear to be a single ‘magic bullet’ replacement for the multi-faceted solution bonds have delivered in recent years. As a result, we believe investors need to build portfolios to meet their specific needs and accept that these probably will not come with the free added extras many bondholders have become used to over the past 30 years. This article will try to outline the main reasons why institutions hold bonds as a key part of their portfolio, and provide a framework for how they can both assess their requirements and meet them in the changed circumstances in which they now find themselves.

New conditions demand new approaches

We are faced with very different economic and market conditions to those before the crisis. Investors broadly accept that future returns in developed bond markets are likely to be below historical averages, yet their fundamental requirements have not necessarily changed much: real returns are still needed, liability payments have still to be met, incomes must still be supported. Unfortunately, given today’s starting point, a traditional bond portfolio anchored to a typical market index is unlikely to meet these requirements, even over the long run. To misquote Einstein, to persist with the same old strategies in a dramatically changed environment and expect the same results is, if not insane, certainly irrational.

So, in addition to the well-rehearsed drawbacks of using traditional fixed income benchmarks, the whole asset class is in a particularly vulnerable position. While active management can mitigate some of these problems by diversifying away from the benchmark, the index-anchoring restrictions in most mandates still serve to limit the benefits. The basic strategies bond managers have historically used in the context of a benchmark-related portfolio are duration, credit, interest rate curve and currency management. Many of these strategies have been highly correlated with the markets themselves, with rewards being available simply for being there. But this is changing.

Trends may not exactly reverse, but will likely become less clear, thus providing good opportunities for active managers – at least those with courage and conviction – to differentiate themselves. We believe institutional investors will need to be commensurately bold.

The opportunity costs of being early are very low from this starting point (yields cannot fall much further). The risk of being late (in other words, staying in index-anchored treasuries when yields start to rise) could be significant. We think that this is no time for complacency.

Understanding the rationale for bond investing

The first step in our framework for action is for investors to consider why they hold bonds in the first place. We outline the most likely reasons below (Figure 2) in broad terms, along with our suggestions for the most important objectives for different types of investor.

Read the full report

Important Information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.
To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.